In the 2002 Berkshire Hathaway annual report, Warren Buffett details how it is that both the discrete and macroeconomic risks of derivative instruments pose a serious threat to the greater financial stakeholder. However, Buffet admits that his firm does use large derivative transactions to facilitate the management of its equity transactions, citing the micro-transactional benefit that can be realized by a party that is able to shift its risks to the financial market. With such a distinction in mind, this paper intends on developing how it is that the risks of derivatives are used in the global financial system to offset discrete financial risks, while replacing them with compounding counter-party risks, as mentioned by Mr. Buffet.
The main argument of Buffet(2002) is that derivative instruments magnify counter-party risks through the way in which they are generally distributed on margin, and without collateralization, a claim supported by Bodie et al(2011), and then redistributed throughout the markets in a way which will “...also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time”(Buffet,2002:15). Buffet(2002) illustrates how it is that this linkage effect has resulted in a situation where a large amount of derivatives risk has been concentrated within a small quantity of dealers, meaning that the capitulation of a single dealer will result in the systemic default of the entire derivative industry. Specifically, OCC(2011) describes how it is that only four institutions control $249 trillion worth of derivatives contracts. This means that American derivatives exposure is worth 18 times the American economy, or 3.57 times the total of all gross domestic products around the world(World Bank,2013). This essentially means that it would take all of the world’s cumulative productive, inflationary, and investment capacity 3.5 years to pay off the effects of a systemic default in the derivatives markets. With that in mind, the OCC(2011) illustrates how it is that interest rate, foreign exchange and credit derivatives present the greatest nominal risk profile to the greater portfolio.
Figure 1) Illustrates the net nominal credit risk associated with various derivative instrument categories (OCC, 2011).
Based on the macroeconomic risks associated with derivative instruments, it stands to reason that Buffet's(2002)’s assertion of the risks of derivatives holds true, mainly due to the way in which the counter-party risk has been magnified over time by a lack of collateralization. Elina(2009) demonstrates how it is that derivative positions can currently be used by acquiring firms to take on undisclosed control positions in an acquisition target, and are therefore in a position to abuse derivative reporting standards to avoid disclosure requirements. This again results in a situation of...